Understanding
Crypto Accounting

Whether an accountant, fund administrator, or simply a cryptocurrency investor, staying up-to-date on the current state of crypto assets can be tedious. Not only do crypto assets exist in a semi-regulated environment that lacks clear-cut definitions and rules, but compliancy when investing in cryptocurrency can be a complicated process.

What’s the best way to account for crypto assets come tax time? What methods can be used to appropriately identify pricing and valuation of these crypto assets? And what role does auditing hold in the crypto asset accounting ecosystem?

To help reduce some of this friction, we answer a few of these questions.

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Understanding Crypto
Asset Reporting & Accounting

As crypto assets continue to penetrate Wall Street institutions, more businesses are leveraging them as legitimate investment vehicles. But bookkeeping and reporting in the space can be confusing. There are no accounting standards that can be directly applied to crypto assets and a serious lack of resources from regulatory bodies, like the IRS — especially when it comes to holding them for investment purposes.

The sheer complexity of crypto assets causes traditional back-office accounting technology to fall short, leaving traders and investors to fend for themselves with unautomated tools and spreadsheets. These solutions do not scale with the volume of transactions that occur in a 24/7 market. Holding just a small number of crypto assets can quickly lead to hyper-complex reporting needs that outpace traditional software solutions.

Below are a few of the challenges with crypto asset reporting.

Crypto Trading

Crypto is 24/7

In order to obtain cryptocurrency, it must either be mined on the blockchain or traded for on an online exchange. Cryptocurrencies work similarly to the Forex market, where currency can be exchanged 24 hours a day. However, unlike Forex, crypto assets are exchanged 24/7, including the weekend. Because there are no official ‘closes’ or closing marks, end of day pricing and valuation of crypto assets is complicated.

Trading is Multi-exchange

Popular exchanges like Coinbase will help users set up a wallet and begin trading fiat currency for crypto assets almost immediately. But there is a small catch: Many Initial Coin Offerings (ICOs) and cryptocurrencies exist in closed trading environments that only accept other major coins as a trade medium. Likewise, some cryptocurrencies are only available on certain exchanges. This means that investors must trade multiple crypto pairs on multiple crypto exchanges in order to gain exposure to specific assets.

Lukka Solves the Complexities

To put this into perspective, Lukka’s back-office software tracks more than 16,000 asset pairs, on over 200 exchanges. In fact, the crypto market is so fractured that no single exchange trades more than 5% of the market share. Each exchange has unique interfaces, infrastructure, and protocols. In fact, many of them have entirely different ticker symbols for the same crypto asset.

Crypto Reference Data

Addressing Inconsistent Tickers

One barrier in valuation and accounting (which we’ll discuss next) is that crypto assets do not have historical reference data. A lack of this data creates issues for several reasons. For starters, ticker data isn’t regulated in the crypto space (see: Which asset does HOT refer to?), meaning that ticker information can change at any time and major exchanges can assign ticker symbols how they see fit. Second, naming convention is not shared between exchanges: two platforms can have different tickers for the same asset. This can make bookkeeping a nightmare without historical reference data to standardize asset tickers.

Standardizing Reporting

This problem goes far beyond a few ticker symbols. With over 200 exchanges running 24/7/365 — each using their own infrastructure, protocols, and ticker symbols — the entire cryptocurrency market is growing more complex daily. Issues are compounded and bookkeeping challenges are quickly leading to inconsistent and non-standardized reporting procedures across businesses.

To learn more, see “The Need for crypto asset Reference Data.”

Crypto Asset Pricing & Valuation

The Need for Specialized Tools

The rise of crypto assets has created new investment opportunities for portfolio managers, but a host of new problems for the middle and back-office, who lack specialized tools to handle them. Friction surrounding pricing and valuation of both liquid and illiquid crypto assets also make investors hesitant to adopt them en masse.

At issuance, the value of a crypto asset is set forth by the terms of its ICO. Once the asset hits the secondary market (a.k.a the exchanges), pricing and valuation becomes increasingly difficult.

Crypto Never Sleeps

Since crypto assets trade 24/7/365, there are no industry-standard closing times or prices, creating confusion around pricing and valuation methodology. These challenges lead to the question, Crypto Asset Valuation: Fair Value or Fair Game? This never-closed nature of crypto has led many to leverage different methodologies to evaluate crypto holdings. Using exchange data (typically from the primary exchange) is one way to value crypto holdings. Volume Weighted Average Price (VWAP) is another popular way to derive it.

Classifying the Complex

Another issue facing the industry is a lack of crypto asset classification. Many businesses separate their crypto assets by type — like cryptocurrencies, utility tokens, digital securities, and illiquid crypto assets (e.g., SAFE or SAFT). This can lead to valuation fluctuations and confusion amongst portfolio managers, auditors, and investors.

Fair Value Accounting

Crypto asset valuation can be tricky for portfolio managers, and we recommend that all portfolio managers who are utilizing cryptocurrency as an investment vehicle (for the sole purpose of creating profits or losses due to market fluctuations) use fair value accounting.

For more information on crypto asset valuation, check out the full transcript to our Crypto Asset Pricing & Valuation Round Table.

Understanding Crypto Asset Taxes

Understanding IRS Regulations

The IRS has been loosely involved with crypto assets, and the current regulatory state is still up-in-the-air, to a degree. The IRS does require that everyone report on crypto holdings and profits, which proves to be a headache. Not only must the price of the currency at the time of trade and the time of utilization be documented and reported, but unclear regulation makes handling tax forms a pain point for many. For more information, view IRS 1040 Virtual Currency: The CPA imperative on Ready, Able, and Accurate

Crypto Defined as Property

To help clarify where crypto assets sit in the tax ecosystem, we need to go back to the International Accounting Standards (IAS). Since cryptocurrencies are not issued by a government or bank, they don’t fall under the definition of cash (or cash equivalents) — as defined in IAS 7 Statement of Cash Flows. Instead, they fit better into the definition for intangible property asset (or inventory) — as defined in IAS 38 Intangible Assets.

Crypto Treated as Inventory

This is the definition that the IRS has gone with: Crypto assets (except in rare circumstances such as some broker-trader relationships) are intangible property and are treated as an inventory.

This means that crypto transactions can incur capital gains tax and therefore, a record must be kept of all crypto asset transactions, including:

Selling crypto assets (mined or acquired) for fiat or other crypto asset

Using crypto assets (mined or acquired) for payments

Remember, the cost basis of the crypto asset, determined at the time of acquisition, should be used to determine gain or loss at the time of disposal. But, can all crypto assets be defined by those same IAS standards?

To learn more about all of these tax challenges, check out the Lukka & Sovos Webinar: Tax Info Reporting Crypto Transactions

Types of Crypto Assets

The diverse nature of crypto assets adds a lot of complexity when it comes to taxes. All crypto assets cannot be categorized under the same banner. Crypto assets can be broken down into the following categories.

  • Traditional cryptocurrency: This is the standard cryptocurrency based on the Bitcoin model. The asset’s value is based on supply and demand, much like other fiat currencies.
  • Utility token: These tokens are utilized to access some software or service. The value of these coins is not supply and demand, but rather the value of the service itself.
  • Security token: These tokens are commonly utilized by ICOs. These are an investment in the entity creating the coin — not the coin itself.
  • Asset-backed cryptocurrency: This is similar to standard cryptocurrency, except the underlying asset isn’t the cryptocurrency itself. Instead, these are backed by other assets (e.g., gold, products, etc.)

Each of these crypto asset types has unique properties and may need to be handled using different taxing models.

Crypto Asset Auditing

In the current crypto ecosystem, many accountants and fund managers wait until an emergency strikes to audit their assets and provide proof of funds. This is a big mistake. Traditionally held accounting principles (like GAAP) were not intended to account for crypto accounting, creating additional friction for many businesses. This leads to the need for Blockchain Auditing – Accelerating the Need for Automated Audits

Auditing will vary drastically between businesses — especially between companies that are using assets for trading/investing vs. holding the asset as inventory. Between identification problems (i.e., is it tangible, intangible, etc.?) and utilization issues in the crypto asset space, accounting should be addressed on an individual basis for each business. Back office software can help standardize crypto assets to facilitate accounting needs, but may still require the assistance of an accountant. For more, listen to Lukka Chief Commercial Officer, Jeremy Drane on the podcast Making Crypto Assets Accountable with Lukka.

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Understanding Crypto Asset Back Office Software

Accounting, taxes, and valuation is typically supported by middle-to-back-office systems. These software solutions improve performance, reduce human error, and help establish and maintain fair accounting principles. However, crypto assets exist in a unique space: They can’t be pushed into traditional back-office systems, and creating custom solutions can cost millions of dollars — a feat typically reserved for massive enterprises with hefty investment portfolios.

At Lukka, we’ve created middle-and-back-office software solutions to meet the needs of the fluid and often chaotic crypto space. This includes:

Lukka Crypto Office: Our middle and back-office software package helps track and nominalize data associated with crypto assets while improving your operational performance and giving you cutting-edge crypto insights. Want to learn more? See our Lukka Crypto Office fact sheet.

Lukka Reference Data: Our master repository of exchanges and asset data keeps you in-the-loop with consistent reference data that’s updated daily across exchanges. Want to learn more? See our Lukka Reference Data fact sheet.

Lukka Pricing and Valuation: Built under GAAP & IFRS guidelines, the Lukka Pricing and Valuation uses custom pricing methodologies, seamlessly integrates with your existing internal pricing sources, and consolidates critical pricing feeds from 3rd parties. Want to learn more? See our Lukka Pricing & Valuation fact sheet.

Our systems support accounting, bookkeeping, and tax for your crypto assets using a blend of APIs while supporting post-trade workflows and illiquid assets. Check out our whitepaper “Institutionalizing Crypto” to learn more.

Final Thoughts

Accounting, taxes, and reporting for crypto assets can be a significant pain point. Not only do crypto assets exist in a unique regulatory space, but tracking, measuring, and analyzing thousands of digital tokens across hundreds of exchanges is almost impossible without the right toolset.

At Lukka, we help investors find their peace-of-mind in the crypto asset space. Our middle and back-office software solutions reduce crypto asset friction and provide best-of-breed practices and workflows for investors to leverage daily. That means less time worrying about crypto asset reporting and more time focusing on what really matters — growing your investment.

Are you interested in learning more about Lukka Tech’s back-office solutions?

Contact us or to learn more about a specific solution, click any of the links below:
Lukka Crypto OfficeLukka Reference DataLukka Pricing & Valuation